Friday, November 9, 2012

Bitcoin is a pretty complex institution. If you're a cryptoanalyst you'll have one explanation for bitcoin, if you're developer you'll have another. What follows is a useful way for monetary economists to think about bitcoin.

What I do in this post is explain how bitcoin compares to a central bank note and a bank deposit. The conclusion is that bitcoin does something truly revolutionary. It also has a lethal problem at its core.

There's two characteristics of a bank deposit. The first is the deposit's intrinsic nature. A deposit is a claim on the credit of the issuing bank. Secondly, these deposits can be traded. The issuing bank keeps a ledger detailing who holds every deposit. When people wish to exchange with each other the prospective trade is announced to the bank. The bank then checks the identities of transactors and verifies that the deposits are there. Then it simply rearranges the pattern of deposits on its ledger.

To abstract from this story, there's the actual "thing" issued, and the record-keeping of that thing.

Central bank-issued notes also have an intrinsic nature. They are claims on the credit of the issuing central bank. As for record-keeping, the central bank doesn't keep a ledger of noteholders. Rather, people spend cash anonymously without announcing trades to the central bank for verification. The only bit of record-keeping the central bank does is record the serial numbers of outstanding notes. The central bank protects its issue from counterfeit paper by strict anti-counterfeiting laws and complex patterns to dissuade copying.

One might say that record-keeping of deposits is finely detailed. Both the quantity and the distribution of deposits are recorded. Record-keeping of central bank notes is coarse and granular. Only quantity, not distribution, is tracked.

Bitcoin also has a record-keeping feature. This mechanism is a fine one, not a granular one. It has to be fine because digital tokens like bitcoin can be easily copied and spent multiple times. This is called the double-spending problem. The bitcoin mechanism gets around the double-spending problem by doing what deposit banks do -- track both the quantity and distribution of bitcoin. When a bitcoin transaction is announced, the bitcoin mechanism checks that the person selling bitcoin has real bitcoin in their possession. Once verified, the mechanism updates its records to indicate that the given quantity of bitcoin has changed ownership.

What makes Bitcoin different from deposit banks is that the process of announcing, verifying, and recording trades is distributed, not centralized. In effect, the ledger has been made public, not private.

The bitcoin ledger, which is made up of a history of every trade of bitcoin in history, is downloaded and stored onto the computers of bitcoin users all over the world. This history is called the Blockchain. When a prospective bitcoin trade is announced, thousands of different computers all over the world hear this announcement. They all independently work to verify that the seller's bitcoin already appear in the Blockchain and are indeed the seller's. The transaction is verified, usually after ten minutes of work, the Blockchain updated, and the new owner of bitcoin can now spend it.

Bitcoin is a revolutionary record-keeping system. It is incredibly fast, efficient, cheap, and safe. I can send my Bitcoin from Canada to someone in Africa, have the transaction verified and cleared in 10 minutes, and only pay a fee of a few cents. Doing the same through the SWIFT system would take days and require a $35 fee. If I were a banker, I'd be afraid.

The lethal problem at the core of the bitcoin mechanism is that a bitcoin has no intrinsic value. Notes and deposits are claims on the credit of the issuing bank, but bitcoin is a claim on no one. Bitcoin are no more than bits, indications that someone has received something. But that "something" is worthless. It's like having a library with the best archival system in the world, yet the only books in the library are filled with empty pages.

For some odd reason Bitcoin have a positive value right now (about $11/BTC). But without an intrinsic tether, I think that bitcoin's price is doomed to hit zero. It will be incredibly sad if the failure of bitcoin's price means that the good aspects of bitcoin - specifically bitcoin-as-record-keeping mechanism - is thrown out with the bath water.

What the bitcoin record-keeping mechanism needs is an already-valuable underlying asset to which it can be tethered. Rather than tracking, verifying, and recording the movement of intrinsically worthless 1s and 0s, it will track the movement of something valuable.

In the future, perhaps someone will create a distributed credit system. Rather than banks lending to people by creating deposits, people will lend to each other by creating deposits. P2P lending. Say these P2P deposits are to be made tradeable, or negotiable. Then you'll need some sort of record-keeping mechanism like bitcoin to track where deposits have gone. Why not tether bitcoin to a P2P credit system? That way you have a P2P credit system and a P2P payments record-keeping mechansim all rolled into one.

It'll be just like the old system of bills of exchange, for anyone who needs evidence.

26 comments:

It's unclear why you think 1's and 0's are worthless. It's unclear what you mean by 'intrinsic' value. Value is subjective. How could you possibly know how anyone else values them? Is the usd worthless because it's not tied to a physical commodity? Could a currency shed your label of 'worthless' if it were tied to a service?

In financial markets, it is usually believed (by both practitioners and economists. Rare agreement!) that financial assets have fundamental values. In that sense, subjective value can be "wrong". If the market prices a financial asset above its fundamental value, this will eventually be corrected via arbitrage. Bitcoin has no fundamental value... unlike a stock or a bond, it doesn't point to a set of underlying assets. Despite the market's subjective valuation of BTC (=$12), arbitrage should send bitcoin down to its fundamental value, $0.

Which leaves the possibility that bitcoin is a commodity like gold. Here I'm not on as firm a ground. You'll notice in this post that I grant the possibility that bitcoin has some non-monetary value. But in a sociological sense (not an economic sense, because you are right that passing judgement on subjective valuations isn't the job of economists) bitcoin's 1s and 0s are not being consumed in any way. So that's why I say bitcoin has no intrinsic value.

The USD is tied to its underlying assets: gold, bonds, MBS, and some other stuff. Doesn't have to be a commodity.

No thing has "intrinsic" value. Items are valued for their usefulness to the actor involved. Bitcoin is valued by many for the things it enables them to do. Bitcoin is a new commodity created to serve market demand for a better medium of exchange.

Bitcoin is not "backed" by anything just like gold is not backed by anything. Bitcoin is what it is. Gold is what it is. Both are commodities which are valued for what they are and what they enable one to do with them.

Not really. People are only using gold, BECAUSE gold has value to many people, but nobody would use it for products if the price of gold would drop to $5 per oz., so it's not like the "usefulness" protects gold from a massive crash. Oxygen and water has non-monetary value, because we actually need it to live and cannot replace it.

Figuring out the size of a liquidity premium is difficult. We're really just making educated guesses. But if gold was no longer useful for its monetary properties (ie. you couldn't easily exchange it anymore), it would still be valued for its...

The usage of gold today doesn't mean that it will be used tomorrow - it's replaceable and it could crash just as fast as bitcoin. If gold crashes to $10 and silver remains stable you'll probably buy a ring made of silver.

Gold does have physical properties that make it a superior metal to silver. Properties that make it desirable for use as jewelry, high luster makes it pretty, high malleability and ductility make it easy to form into a desired shape. Chemically it is stable and will not rust or degrade in quality. Excellent conduction of heat and electricity make it ideal for high performance electronics however these are secondary as jewelry accounts for 75% of global gold use. These are all things that silver can do well but not nearly at the same level as gold.

The physical properties of gold are what make gold desirable in the first place and have created a continued culturally driven demand for the rare, beautiful metal that is perfect for making pretty shapes with. It is much easier to argue that gold has more "intrinsic value" than silver and is of comparable worth to other commodities with practical (though one can argue against the practical purpose of jewelry) physical uses.

How Bitcoin carries an "intrinsic value" is a bit more ill-defined since it is not comparable to gold or another commodity in the way that a commodity possesses desirable physical qualities. What Bitcoin does have is desirable functional qualities. Bitcoin is, as of now, a cryptographically secure, anonymous, and quick method of transferring "value" using the best architectural features of the internet. The functional properties of Bitcoin are what give it a non-monetary value, a very different type of value than gold but one that is not something to dismiss.

Why does bitcoin have to have a non- monetary value? I don't think it needs to even though it does. Bitcoin can be used in smart contracts and it is being used as a public title registry.

As stated above, bitcoin is a new commodity created (invented) to serve market demand for a better medium of exchange. It doesn't have to have any other use or purpose. It is an "opt in" community currency that people can voluntarily accept or reject. I believe it has enduring qualities but everybody doesn't have to agree with me.

It needs to have a non-monetary value because it doesn't have fundamental value (ie. it doesn't point to a set of underlying assets, as a bond or a stock does), not does the government force people to pay taxes with it.

With none of these 3 characteristics, bitcoin is a theoretical anomaly. It could mean that we need new theories. It could mean bitcoin will fall to zero. I'm curious to see which. As a betting man, I'd lean towards the latter.

Bitcoin decreases transaction costs. Media of exchange that have higher liquidity than Bitcoin (e.g. fiat currencies or commodity currencies) cannot compete with Bitcoin on transaction costs, and altcoins do not have comparable liquidity to Bitcoin. So Bitcoin has value primarily due to exogenous factors, i.e. the state of its existing and hypothetical competitors and the comparative advantage it has over them.

If there was an underlying backing to Bitcoin, that would, counter to what intuition says, increase its transaction costs (due to redeemability). Then the exchanges would collapse (as the value of Bitcoin would be generated by the backing, so there would be no need to have a separate bid-ask spread). This would extinguish practically all liquidity and lead to Bitcoin's collapse.

Bitcoin will have value as long as there is no better alternative, similarly as other pure network goods, e.g. the IPv4 protocol (which bears a lot of economic similarities to Bitcoin). IPv4 addresses are also purely virtual, irredeemable and unconsumable, yet they do have a non-zero price and noone is worried about them collapsing.

At my presentation at the Bitcoin conference in London, I presented a 2x2 matrix of possible reasons for Bitcoin's collapse. I plan to have it published very soon.

I look forward to reading your presentation. I've seen your name before, maybe David Glasner's blog?

I'm not sure I agree with your comparison of bitcoin to IP addresses. Say that an IP address you own can never be traded again. What can you do with it? Well, you can use it to host websites. Now say that a bitcoin you own can never be traded again. What can you do with it? As far as I can, nothing. Btc is unique because it has neither financial backing, nor does it have a non-monetary commodity/consumption value.

I've been posting about Bitcoin in random places for about 1.5 years, one of the places was on Glasner's blog if memory serves right, so that's possible.

The point is, you can host websites on an IP(v4), but if noone else uses an IPv4 to view websites (e.g. because they moved to IPv6), then it's useless for you to have one. Or human languages, they also can die out. It's like asking why you should learn Esperanto, because people can lose interest in Esperanto and they you have sunk costs and no way to recover them. These are other examples of pure abstract network goods: the only way to use them is within a context of social interaction.

First of all, you can recover the costs (maybe) before the time the public's interest runs out. For example, on the saved transaction fees. If you maintain a balance of, say, 100 bitcoins, and use them in your trades, assuming Bitcoin lowers your costs by 1% compared to other solutions, then at a total transaction volume of 10.000 you break even. There are types of businesses that have a high turnover compared to their cash balances, and other types of businesses that are either highly sensitive to transaction costs or that face a more significant transaction cost reduction through the use of Bitcoin, so the risks of these are lower.

Second of all, Bitcoin is a medium of exchange. If it was to collapse, it requires that people who use it switch to something else instead. Like they need to switch from IPv4 to IPv6, or from Esperanto to English, for example. They wouldn't switch from computer networks to letters, or from language communication to non-verbal communication, that's extremely unlikely.

What would the people abandoning Bitcoin switch to? Other cryptocurrencies have lower liquidity (as you yourself demonstrated very well on the chart with market capitalisation), and fiat money and/or commodity monies have higher transaction costs. So something would need to change in one of these two areas to motivate the switch. That's not impossible (indeed, I tried to explain at my presentation how it can happen), but it would have to be something pretty significant.

So I wouldn't worry about it too much. And even if it happens, there probably would be leading indicators showing that the risk increased. I'll let you know once there's something published in a more proper way by me (I'm actually working on launching a Bitcoin economics blog and I plan to post my stuff there).

Your point on Esperanto is one I've heard before. It's the "language theory of money". I'm not too keen on it. A medium of exchange is an asset that gets traded and priced. Words are not. So it's tough to draw a comparison between mediums of exchange and language. Maybe I'll write a post on it in the future. Part of my reasoning can be seen in this post on the social contrivance of money.

Your point on transaction costs makes sense except that people don't really use bitcoin for transactions. It seems mainly to be used for speculation and gambling (Satoshi Dice). I've had problems finding places to spend my bitcoin, at least for consumables. I wouldn't say its saved me on transaction fees.

In any case, as Gavin Anderson always points out, bitcoin is an experiment. If it works out, we'll need new monetary theories too.

I wouldn't say that there's no place to spend it on consumables - it's just not entirely legal. There's an entire network (detailed by Gawker in this post: http://gizmodo.com/5927379/the-secret-online-weapons-store-thatll-sell-anyone-anything) of illegal goods and services that are being sold via what has been branded by the media as the "darknet".

All that said, I don't particularly disagree with you about the intrensic value of bitcoin (or the lack thereof) as it's a currency with value that is entirely predicated by its own transaction medium.

The purchasing power is almost entirely driven by the fact that it exists outside of government regulation, which will ultimately be its failing when the proverbial shit hits the fan and something goes wrong. A currency's value should eventually graviate toward it's real long-term equilibrium. Thus, I have to assume in the absence of market forces, the equilibrium point of this currency is going to be zero.

Additionally, when you consider that the currency is suffering from hyperdeflation, there's going to be a serious hoarding problem in the market soon - as things are cheaper to buy in the future if the purchasing power of the currency continues to rise. Ultimately, the bitcoin experiment is going to meet an untimely end sometime in the future.

JP, have you read Peter Surda's paper since it has been released? Also, I think Trace Mayer's explanation of why bitcoin is tangible helps to explain why people value it: http://www.runtogold.com/2012/11/why-bitcoin-is-tangible-digging-into-the-guts-of-bitcoin/

Also, the blockchain does have other uses besides as a ledger: smart contracts, signatures, etc, so one can argue that it meets the requirements for non-monetary use -- although I do not believe that is necessary for something to have monetary value to people.

http://www.gwern.net/Bitcoin%20is%20Worse%20is%20Better - good paper (2011) by economists and computer scientists on why BitCoin is doomed long term, and how to improve it now. The author, while misinformed about BitCoin values, is to be commended for explaining to laypeople how BitCoin money is authenticated in about 10 minutes without a 'central depository' of records.